The Variable Interest Entity seems like a “Deliberate Nod and Wink”

Michael Brennan, a renowned academic in the field of finance, on the variable interest entity structure, China’s capital markets and the internationalization of the renminbi.

Michael Brennan, Professor of Finance at both UCLA Anderson and London Business School, recently visited CKGSB to share his latest research on rational variation in expected returns on stocks, as well as sentiment-driven variation. During his visit, Brennan, an expert on asset pricing, corporate finance and the role of information in capital markets, shared his thoughts on a wide range of issues surrounding the Chinese economy and its impact on the rest of the world. He discussed, among other things, the internationalization of the RMB; the variable interest entity structure of Chinese companies listing abroad; and the globalization of China’s capital markets. Read on for an outside-in perspective on China.

Q. What are your thoughts on the globalization of Chinese capital markets?

A. Removing capital controls on outflows would seem to be unambiguously a good thing for everyone, because it would improve international relations with the US and it would improve the welfare of Chinese citizens. It would improve relations, because the renminbi would be kept down by private capital flows rather than public capital flows and I suspect private Chinese capital flows, portfolio flows, would be much more acceptable to the rest of the world than purchases by the Chinese government.

More importantly, it would improve the investment opportunities of Chinese people who are stuck investing either in Chinese stocks, which seem to be a little bubbly, or in low-interest deposits or wealth management products, which seem a little bit dodgy to me.

As I understand it, retirement is not very well developed in China, so people are largely left on their own to save for their retirement. Many do this by buying apartments and there may be a certain amount of overbuilding of apartments as a result of that, as well as too much misallocation of capital. So I think it would be very much in the interests of the Chinese people to have a broader set of investment opportunities.

Q. In terms of the internationalization of the renminbi, the government has said that it will be freely floated at some point in the future. Do you see the process moving at the pace that you’d like it to move at?

Michael Brennan, Professor of Finance at UCLA Anderson and London Business School

A. I think the danger for removing capital controls is the stability of the Chinese banking system. If foreigners are going to have deposits in the Chinese banking system, I think the banking system has to be a whole lot more transparent, otherwise there are likely to be significant capital outflows when things look bad. There is plenty of history of other countries, for example in 1998, getting into real trouble with capital outflows, and I think that China would be especially vulnerable because of the opacity of the banking system.

Q. What is your sense about what the real value of the renminbi is, if it were to be freely floated?

A. If you set it up freely floated, it depends whether or not you have capital controls. So you’ve got to take into account the capital flows as well as the trade balance. The trade balance is obviously very favorable right now, so it’s likely that the renminbi is undervalued on trade balance.

Q. What’s your outlook on the global financial markets and how they might affect China?

A. I think it’s surprising how well financial markets have done. The one striking aspect is how low interest rates are and how low they are expected to remain judging by the forward rates and long-term rates, and that seems like very bad news in the sense that people are implicitly projecting that the real return on capital is close to zero. That seems like a very bad sign. Stock prices are remarkably high, but that’s partly reflected in the very low returns on other aspects.

If we ever get into an inflation situation again, and inflation has obviously been depressed over the last 15 or 20 years by the rise of China among other things, but that’s could be pretty important. We’ve been pouring petrol on the fire with monetary policy and quantitative easing, it’s just that nobody has put a match to it. I don’t quite understand why we’ve managed to keep prices so low. Goods prices have remained low, but asset prices have gone shooting up and that’s seems to be a worldwide phenomenon. So either goods prices are going to catch up or asset prices are going to catch up. There seems to be a mismatch.

Q. What aspect of China’s economy are you most worried about?

A. In terms of the overall framework, from what I understand, there are issues of transparency and of legal contracting and of the judicial system. I think that is going to be the greatest impediment for China going forward. It’s just hard for people to contract with people in China.

Q. Is it good for the global economy when Chinese companies choose to list abroad? Is it bad for China? What’s your view on that?

A. In principle, it’s obviously better to have more freedom for Chinese companies to invest overseas and for foreign companies to be able to list in China. I think that the welfare benefits of foreign companies listing in China are possibly greater because it improves the investment opportunities of Chinese investors. For Chinese companies investing overseas, there are certainly a lot of people in North America and Europe who would like to have a piece of the Chinese action. But the Chinese action doesn’t seem to have been so much in the capital markets in terms of stock returns as it does in the real economy where it is obviously doing extremely well. The question is, why have Chinese stocks done very well relative to the phenomenal real performance? I think you have to look at problems such as crony capitalism or problems with the judicial system, of insiders being able to advantage of outsiders, of a lack of transparency, accounting, and so on.

One benefit to having Chinese companies investing in the US is if the US insists on transparency and governance standards for companies to list. Now, as far as I can see, the US isn’t doing that at present.

For the capital flow implications, they are somewhat perverse in the sense that China is lending the US tens of billions of dollars a year to buy flat screen TVs, more houses, SUVs, and so on. It doesn’t make sense for a relatively poor country like China to be lending money to a relatively rich country like the US. This just seems to me like a disequilibrium phenomenon. So if a company like Alibaba lists in the US, makes an IPO in the US, then that is just a reverse capital flow from the US to China which has to be offset by a bigger official capital flow, so that $25 billion [from Alibaba’s IPO] will put pressure on the renminbi and the government will have to step in and offset that. I don’t think that accomplishes much at all.

Q. When you talked about the US not insisting on transparency, does the variable interest entity (VIE) structure of a lot of Chinese internet stocks come into play? What do you think about that?

A. In general, I think it’s deplorable. First of all, the Chinese government has rules about internet ownership. Either it’s serious about these rules or it’s not. If it’s not serious about them, then it should get rid of them. If it is serious about them, then I suggest it should enforce them. The variable interest entity thing seems like a deliberate nod and a wink to go around these rules, but it introduces uncertainty as to whether the rules will subsequently be resurrected and enforced, and that’s with all the uncertainties of the Chinese legal system, so it’s very problematic. If you want a strong opinion on this, I would say do not invest in these things.

Q. So even though many other companies have been doing this for many years, you think it could all come crashing down at some point?

A. Well, if the Chinese government is allowing it (variable interest entity), why do they retain the law prohibiting it? That seems to be an inconsistency there. And it’s one that is not good for China, because if they decide to enforce the law, then it’s going to be Chinese versus the rest, versus foreign investors–and that’s not very helpful.

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